Introduction to Risk, Return and the Historical Record - PowerPoint PPT Presentation

Introduction to Risk, Return and the Historical Record. P.V. Viswanath For a First Course in INvestments. Learning Goals. How are interest rates determined? How can we compare rates of return for different holding periods? What is the relation between inflation rates and interest rates?

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Both suppliers and demanders of capital thus determine their supply and demand for capital at different real rates of interest.

However, since loan contracts are nominal, they have to contract for a nominal rate of return. To ensure that the resulting real return is consistent with what they are looking for, they forecast the expected inflation rate and add that to the desired real rate of return and then come up with the desired nominal rate of return or nominal rate of interest.

Assuming that investors’ time preference for real resources do not vary too much over time, changes in the nominal interest rate will simply track changes in the inflation rate.

However, this assumes that the inflation rate is easy to predict. Changes in the money supply are the primary determinant of the inflation rate and unfortunately, changes in the money supply can be difficult to forecast.

Furthermore, there is a certain amount of money illusion. People think and contract, to some extent, in terms of nominal prices and nominal quantities. As a result, changes in money supply could also have an impact on real quantities.

In addition, money is needed as a medium of exchange. Hence it has a “real” role in the economy, as well. Hence the nominal side of the economy could affect the real economy.

If there were complete inflation illusion and the nominal interest rate were constant, the inflation rate would be uncorrelated with the nominal interest rate.

On the other hand, if the Fisher Hypothesis held, and if expected real interest rates were relatively constant, then nominal interest rates would move one-to-one with inflation rates.

Up to 1967, there seems to have been money illusion, since the correlation of the inflation rate with the nominal T-bill rate was close to zero (r = -0.17). However, since 1968, the correlation has increased (r = 0.64). This suggests that markets are less subject to money illusion.

The next graph shows the much closer connection between interest rates and inflation in the post-1967 period.

If the Fisher Hypothesis held, and the real interest rate were constant, then the realized real T-bill rate (i.e. nominal minus inflation) should be perfectly negatively correlated with the inflation rate, because any increase in inflation would reduce the realized real rate by an equal amount. R = r + E(i) = r + i + E(i) – i or R-i = r + E(i) – iIf r and E(i) are constant, then Corr(R-i, i) should be -1.0Corr(R-i, i)= Corr(r, i) + Corr(E(i), i) –Corr(i, i) = 0+0-1 = -1.0, where Corr(r, i) = 0, because under the Fisher Hypothesis, the real and nominal sectors are uncorrelated.

In practice, this correlation has been about -0.44 after 1967, compared to -1.0 before 1967.

This suggests that the nominal rates are not keeping pace with expected inflation. This would happen if real rates and inflation rates were positively correlated. That is, the real and nominal sectors of the economy are connected – Corr(r, i) > 0.

Watch this youtube video and see what’s wrong with the arguments made.

The next two graphs will show that bond and equity returns are volatile. As a result, it’s not sufficient for an investor to simply look at average returns; it’s necessary to look at average returns in comparison to volatility.